Derivatives - types and scope

1. Financial Derivatives
⁃ Definition
⁃ Participants
⁃ Markets
⁃ Benefits
⁃ Types
What are derivatives?
• A derivative is a financial instrument

2. whose value is derived from the value of
another asset, which is known as
underlying asset.
• When the price of the underlying
changes, the value of the derivative also
changes.
• A derivative is not a product. It is a
contract that derives its value from
changes in the price of the underlying.
• The value of the gold futures contract is

3. derived from the value of the underlying
asset, which is gold.
Traders in the derivatives market.
• Hedger - A hedger faces the risk
associated with price movement of an
asset and who uses derivatives as
means of reducing risk.
• Speculator - A trader who enters the
futures market in pursuit of profit,

4. accepting risk in the endeavour.
• A r b i t r a g e u r - A p e r s o n w h o
simultaneously enters into transactions in
two or more markets to take advantage
of the discrepancies between prices in
the market.
⁃ Arbitrage involves making profits from
relative mis-pricing.
⁃ It also help to make markets liquid,
ensure accurate and uniform pricing, and

5. enhance price stability.
Types of Derivatives Market
• OTC
⁃ In over-the-counter market derivatives
are traded between two counter-parties
without going through an intermediary.
⁃ The contract is privately negotiated and
thus customised.
⁃ T h e s e m a r k e t s a r e g e n e r a l l y

6. unregulated.
• Exchange-Traded
⁃ The exchange acts as an intermediary
whenever a contract is negotiated
between two counter parties.
⁃ The trading is standardised and
regulated.
⁃ The KOSPI of South Korea is the world's
largest derivatives exchange (by the

7. number of transactions)
Economic benefits of derivatives
⁃ Reduces risk.
⁃ Enhances liquidity of the underlying
asset.
⁃ Lowers transaction cost.
⁃ Enhances the price discovery process.
⁃ Portfolio management.
⁃ Provides signals for market movements.

8. ⁃ Facilitates financial markets integration.
Types of derivatives
1. Forward
2. Futures
3. Options
4. Swaps
What are forward contracts?
⁃ A forward is a contract in which one

9. party commits to buy and the other party
commits to sell a specified quantity of an
agreed upon asset for a pre-determined
price at a specified date in the future.
⁃ It is a customised contract, in the sense
that the terms of the contract are agreed
upon by the individual parties.
⁃ Hence, it is traded at OTC.
Risks in forward contract

10. • Credit risk - Does the other party have
the means to pay?
• Operational risk - Will the other party
make delivery? Will the other party
accept delivery?
• Liquidity risk - In case either party wants
to opt out of the contract, how to find
another counter party?
What are Futures contract?

11. ⁃ A future is a standardised forward
contract.
⁃ It is traded on an organised exchange.
⁃ It is standardised in terms of - quantity,
price and date of delivery of the
underlying.
Types of futures contracts
⁃ Stock futures trading
⁃ Commodity futures trading

12. ⁃ Index futures trading
Closing a futures position
⁃ Most futures contracts are not held till
expiry, but closed before that.
⁃ If held till expiry, they are generally
settled by delivery (2%-3%).
⁃ By closing a futures contract before
expiry, the net difference is settled
between traders, without physical

13. delivery of the underlying.
Terminology
⁃ Contract size - The amount of the asset
that has to be delivered under one
contract. All futures are sold in multiple of
lots which is decided by the exchange
board.
⁃ Contract cycle - The period for which a
contract trades. The futures on the NSE

14. have one (near) month, two (next) month
and three (far) month expiry cycles.
⁃ Expiry date - Usually last thursday of
each month or previous day if thursday is
a public holiday.
⁃ Strike price - The agreed price of the deal
is called the strike price.
⁃ Cost of Carry -Difference between strike
price and current price.

15. Margins
⁃ A margin is an amount of a money that
must be deposited with the clearing
house by both buyers and sellers in a
margin account in order to open a futures
contract.
⁃ It ensures performance of the terms of
contract.
⁃ It aims to minimise the risk of default by
either counterparty.

16. Types of margins
• Initial margin - Deposit that a trader must
make before trading any futures. Usually,
10% of the contract.
• Maintenance margin - When a margin
reaches a minimum maintenance level,
the trader is required to bring the margin
back to its initial level. The maintenance
margin is generally about 75% of the
initial margin.

17. • Variation margin - Additional margin
required to bring an account up to the
required level.
• Margin call - If amount in the margin A/C
falls below the maintenance level, a
margin call is made to fill the gap.
Marking to Market
⁃ This is a practice of periodically adjusting
the margin account by adding or

18. subtracting funds based on changes in
market value to reflect the investor's gain
or loss.
⁃ This leads to changes in margin amount
daily.
⁃ This ensures that there are no defaults
by the parties.
What are options
Contracts that give the holder the option to

19. sell/buy specified quantity of underlying at a
particular price on or before the specified
time period.
The word "option" means that the holder
has the right but not the obligation to buy/
sell underlying asset.
Types of option
• Options are of two types - Call and Put.
• Call option give the buyer the right but

20. not the obligation to buy a given quantity
of the underlying asset, at a given price
on or before a particular date by paying a
premium.
• Put option gives the buyer the right, but
not the obligation to sell a given quantity
of the underlying asset at a given price
on or before a particular date by paying a
premium.
• The other two types of option are -

21. European and American options.
• European style options can be exercised
only on the maturity of the options,
known as expiry date.
• American style option can be exercised
at any time prior to the expiration date.
Features of options
⁃ A fixed maturity date on which they
expire.

22. ⁃ The price at which option is exercised is
called exercise price of an option.
⁃ The person who writes the option and is
the seller is referred to as "option writer".
⁃ The person who holds the option and is
the buyer is called "option holder".
⁃ The premium is the price paid for the
option by the buyer to the seller.
⁃ A clearing house is interposed between
the writer and the buyer which

23. guarantees performance of the contract.
What are swaps?
⁃ In a swap a counter parties agree to
enter into a contractual agreement
wherein they agree to exchange cash
flows at regular intervals.
⁃ Most swaps are traded over the counter.
⁃ Some are traded on futures exchange
market.

24. Types of Swaps
There are two main types of swaps-
⁃ Plain vanilla fixed or floating swaps or
simply interest rate swaps.
⁃ Fixed currency swaps or simply currency
swaps.
What is an Interest rate swap?
⁃ A company agrees to pay a pre-
determined fixed interest rate on a

25. notional principal for a fixed number of
years.
⁃ In return, to receives interest at a floating
rate on the same notional principal for
the same period of time.
⁃ The principal is not exchanged. Hence, it
is called a notional amount.
Floating Interest rate
⁃ LIBOR - London Interbank offered rate.

26. ⁃ Its an average interest rate estimated by
leading banks in London.
⁃ Its the primary benchmark for short term
interest rates around the world.
⁃ Similarly, there is MIBOR i.e. Mumbai
Interbank Offered rate.
⁃ It is calculated by the NSE as a weighted
average of lending rates of a group of
banks.

27. What is a Currency Swap
⁃ It is a swap that includes exchange of
principal and interest in one currency for
the same in another currency.
⁃ It is considered to be a foreign exchange
transaction.
⁃ It is not required by law to be shown in
balance sheet.
⁃ The principal may be exchanged either at
the beginning or at the end of the tenure.

28. ⁃ However, if it is exchanged at the end of
the life of the swap, then the principal
value may be very different.
⁃ It is generally used to hedge against
exchange rate fluctuations.